Sources of Capital: Leasing Companies

Venture leasing companies generally provide equipment for start-up and emerging growth companies. There tend to be two types of venture leasing:

The first type is offered by traditional leasing companies that have targeted venture capital-backed businesses and have tailored their marketing and product structure. In this case they do not seek an equity position in the lessee. These firms usually require a minimum level of venture funding be invested and full financial disclosure. The transaction is usually structured as an operating or true lease for 18 to 36 months, and is for equipment that is essential to the operations of the business.

The second type is offered by a venture leasing company that seeks an equity stake in the lessee, typically in the form of warrants or options. The lessee has generally received venture investment and is evaluated based on its growth potential. Typically there is no deposit required with regard to the lease transaction, and it is structured for a three-to-four-year term. As in the prior paragraph, full financial disclosure is required.

When negotiating with a venture leasing firm, the concept is to seek a lower interest rate and lower payments in exchange for warrants, given that the strike price of the warrants is appropriate. In an ideal situation, the warrants will be at or above the current equity valuation. Venture leasing can be a less dilutive financing alternative than raising additional venture funds.

Equipment Leasing

When a company leases equipment, it benefits from the asset's use, not its ownership. As a result, the company does not consume capital that can be used for expansion, growth, or other resource acquisition. Leases are made based on the value of the asset and the credit quality of the borrower. 1

Leasing companies can be independent finance businesses or units of banks. They provide capital by procuring equipment for their clients in exchange for a commitment of a series of payments. Some leasing companies focus on specific industries and have special programs tailored for certain types of equipment, while others are broad-based in scope. Those with industry specialization sometimes have the ability to be more aggressive in pricing given their understanding of the equipment values and paths to liquidation or resale. In some cases and depending on the amount of the lease, leases are easier to obtain and less sensitive to the customer's creditworthiness, particularly when the equipment being leased is ordinary.

When considering leasing as a financing alternative, ask the following questions: 2

How long will your company need to use the equipment?

What does your company intend to do with the equipment at the end of the lease?

What is the tax impact of a lease given the company's tax situation?

How will the lease impact your tax situation?

What are the company's expected future needs, and how does the lease fit into a total financing plan?

Types of Leases

For financial reporting purposes, leases can be divided into two categories: capital leases and operating leases. An operating lease is a shortterm lease or usage agreement that allows the company (lessee) to acquire use of an asset for a fraction of the asset's useful life. This type of lease is accounted for by the lessee without showing the asset or liability (for the lease payment obligations) on the balance sheet. The lessee accounts for rental payments as an operating expense on the income statement. 3 For example, a company may enter an operating lease to rent a computer system for a year. Operating leases should appear as a note to the balance sheet to disclose the annual amount of minimum rental payments for which the company is obligated, the general terms of the lease, and any other relevant information. The benefits of an operating lease include the reduced risk of asset obsolescence (for technology equipment) and off-balance-sheet financing, allowing a company to effectively borrow additional long-term capital without negatively impacting its debt-to-equity ratio.

An operating lease must possess all of the following elements to meet Financial Accounting Standards Board (FASB) rules:

Lease term is less than 75 percent of estimated economic life of the equipment.

Present value of lease payments is less than 90 percent of the equipment's fair market value.

Title does not pass automatically to the lessee at the end of the lease term.

A capital lease is a direct substitute for the purchase of an asset with a term loan. It is a noncancelable contract to make a series of payments in return for use of an asset for a specified period of time. It transfers substantially all the benefits and risks inherent in the ownership of the property to the lessee. Typical terms transfer the asset to the company at the end of the lease or allow the company to purchase the asset for a minimal price. Interest and depreciation are expensed as payments are made against the capital lease. A capital lease tends to generate expenses sooner than an equivalent operating lease.

In both operating and capital leases, there is usually some type of deposit required. It is sometimes in the form of prepayment of the first and last payments.

Sale Leaseback

A company can unlock or reallocate existing capital by selling existing assets to a leasing or finance company with an agreement to lease those same assets over time; this is referred to as a sale leaseback arrangement. This technique is useful for companies that have already invested in certain fixed assets and need to shift the use of that capital. It is also a viable technique for companies that have equity in real estate. There are tax implications, so we counsel a company to evaluate that impact. Some venture leasing firms will do a sale leaseback arrangement with early stage companies that have already invested in fixed assets. This may be an alternative for asset-intensive venture-backed companies that are between rounds and need additional capital to meet their next milestones, yet do not want to further dilute the founders' shares by accepting a premature round.